How debt consolidation loans work
If you have a pile of debt — even if you’re managing to pay the bills every month — it might feel like you’re not making headway on what you owe. That’s when debt consolidation can help.
Debt consolidation is when you roll multiple debts into one loan that has one monthly payment and one (hopefully lower) interest rate. This can help you stay organized and possibly save money.
What is a debt consolidation loan?
A debt consolidation loan is one way to refinance your debt. You’ll apply for a loan for the amount that you owe on your existing debts, and once approved, you’ll use the funds to pay off your debt balances. Then you’ll pay down the new loan over time.
When choosing a debt consolidation loan, you’ll have to evaluate a few different features:
- Loan type: The most common loan types include personal loans, credit cards with an introductory 0 percent APR, 401(k) loans and home equity loans.
- Loan terms: The loan amount, interest rate and length of the loan depend on the type of loan you get and your financial health.
- Secured versus unsecured: With secured loan, you have to put down collateral. For example, a home equity loan is secured by your home. If you fall behind on payments, the lender can take that collateral to satisfy your unpaid balance. If you don’t want to risk your assets, consider sticking to your unsecured options, such as personal loans and 0 percent APR credit cards.
How does a debt consolidation loan work?
Most debt consolidation loans are fixed-rate installment loans, which means the interest rate never changes and you make one predictable payment every month. So if you have three credit cards with different interest rates and minimum payments, you could use a debt consolidation loan to pay off those credit cards — leaving you with just one monthly payment to manage instead of three.
Let’s say you’re paying down credit card debt. Here’s how a debt consolidation loan can help you save on interest costs:
- Card 1 has a balance of $5,000 with an APR of 20 percent.
- Card 2 has a balance of $2,000 with an APR of 25 percent.
- Card 3 has a balance of $1,000 with an APR of 16 percent.
If you pay down these credit card balances over 12 months, your interest costs would amount to $927. But let’s say you take out a 12-month personal loan for the amount you owe — $8,000 — with a 10 percent APR. If you pay off the loan in one year, you knock down the interest cost to just $440. To calculate the savings on your own debt, try using a credit card payoff calculator and a personal loan calculator.
Benefits of a debt consolidation loan
If you’re looking to save money, streamline your monthly payments and circle the payoff date on your calendar, then debt consolidation may be a good fit for you. Here’s a breakdown of the main benefits:
- Pay down debt quicker. Making the minimum payment on your credit cards can stretch out your repayment timeline for years. A debt consolidation loan may put you on a faster track to payoff.
- Save on interest costs. Generally, if you qualify for a lower rate than what you’re paying now, you’ll save money on interest costs. As of late October 2020, the average credit card interest rate was 16.02 percent, while the average personal loan rate was 11.88 percent.
- Simplify your monthly payments. It’s easier to manage one monthly payment than multiple payments with different due dates. This reduces your chances of missing payments, which is good for your credit.
- Repay on a fixed schedule. Many debt consolidation loans are fixed installment loans, which means you’ll know exactly when you’ll be debt-free. This can help motivate you while you pay down debt.
Risks of a debt consolidation loan
You’ll need to weigh your immediate needs with your long-term goals before moving forward. Some people choose to consolidate debt to save money and organize their monthly payments, but there are downsides to consider.
- It won’t solve all your financial issues. Once you use the debt consolidation loan to pay off your debt, you might be tempted to start using your credit cards again. This increases your overall debt, which can impact your credit and make it harder to pay down your balances.
- There may be some upfront costs. Some debt consolidation loans come with fees, including origination fees, balance transfer fees, prepayment penalties, annual fees and more. Before taking out the loan, ask the lender whether any of these apply.
- You may pay more in interest. This might happen in two ways. Depending on your credit score, debt-to-income ratio and loan amount, you might pay a higher interest rate than you would on the original debt. Or, if you use the debt consolidation loan to lower your monthly payments by stretching out your repayment term, you may end up paying more in interest in the long run.
Understanding debt consolidation loan interest rates
When you pay back a debt consolidation loan, you’re not just paying back the amount you borrowed — you’ll also pay an additional sum each month in the form of interest. Interest rates on debt consolidation loans generally range from 5.99 percent to 35.99 percent. A higher interest rate will cost you more over the life of the loan than a lower interest rate. Every lender has different criteria for setting rates, so shopping around can help you find the best deal.
Generally, lenders check these factors when deciding if you qualify and setting your interest rate:
- Your credit score: Borrowers typically need a credit score in the mid-600s to qualify for a debt consolidation loan, and a higher score may help you get a lower interest rate.
- Your DTI ratio: Your debt-to-income (DTI) ratio shows lenders how much of your monthly income goes toward debt payments. Lenders tend to look for a lower DTI ratio.
- Income: The lender will verify your employment and check that you earn enough to make payments.
If you don’t quite meet the credit requirements, you may be able to find a lender that’s willing to extend you a loan, although you may get a higher interest rate. If you’re in this situation, consider adding a co-signer to the loan. This person promises to take over payments if you fall behind — so they should understand what’s involved before saying yes.
How to apply for a debt consolidation loan
There’s a little bit of legwork involved, but it will pay off if a debt consolidation loan saves you money. Start by pulling your credit, comparing quotes among multiple lenders and checking your chances for loan approval.
- Understand your finances. A strong credit score gives you a better chance at qualifying for a debt consolidation loan and getting a good interest rate. Check your credit score before applying to see if it needs work.
- Compare lender terms. Shopping around for the best deal can help you save money on debt consolidation. Get quotes from multiple lenders and compare the interest rate, fees, loan term and monthly payment.
- Get prequalified. Some lenders offer prequalification, which gives you a sneak peek of the kind of offers you may receive. Many can perform only a soft credit pull, which means the prequalification won’t affect your credit score.
- Gather what you need to apply. When applying for a debt consolidation loan, you might need your Social Security number and contact information, an estimate of your monthly debt obligations and a pay stub and employer information to prove income.
Once you’re approved, the lender may disburse your loan proceeds to your creditors or send the funds to you. Make sure the original debt is paid off, then get to work on your new loan. Set up automatic payments or use reminders to make on-time payments every month. Over time, you’ll be debt-free.
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